Indias economic reforms
began in 1991 when a newly elected Congress government, facing an exceptionally
severe balance of payments crisis, embarked on a programme of short term
stabilisation combined with a longer term programme of comprehensive structural
reforms. Rethinking on economic policy had begun earlier in the mid-eighties
by when the limitations of a development strategy based on import substitution,
public sector dominance and pervasive government control over the private
sector had become evident, but the policy response at the time was limited
to liberalising particular aspects of the control system without changing
the system itself in any fundamental way. The reforms initiated in 1991
were different precisely because they recognised the need for a system
change, involving liberalisation of government controls, a larger role
for the private sector and greater integration with the world economy.

The broad outline of the
reforms was not very different from the reforms undertaken by many developing
countries in the 1980s. Where Indias reforms differed was the much
more gradualist pace at which they were implemented. The compulsions of
democratic politics in a pluralist society made it necessary to evolve
a sufficient consensus across disparate (and often very vocal) interests
before policy changes could be implemented and this meant that the pace
of reforms was often frustratingly slow. Daniel Yergin (1997) captures
the mood of frustration when he wonders whether the Hindu rate of growth
has been replaced by the Hindu rate of change! Yet even a gradualist process
can achieve significant results over time and Indias reforms have
been underway now for seven years. . That a consensus of sorts has evolved
is perhaps reflected in the fact that the reforms initiated by the Congress
Government in 1991 were continued by the United Front coalition which
came to power in 1996 and have also been broadly endorsed by the BJP led
government which took office in 1998. This is not to say that economic
policy issues are no longer controversial and there is complete consensus
on all points. Differences do exist, especially in emphases and nuance
but these are often as much evident within parties as across the political
spectrum.

3. This paper attempts to
evaluate what has been achieved by gradualism in this seven year period
which has seen three different governments in office - the Congress government
which initiated the reforms in 1991, the United Front coalition which
continued the process in 1996 and 1997 and finally the BJP led coalition
which took office in March 1998 and has also declared its intention of
strengthening the reforms. The paper distinguishes between achievements
in terms of the end results in terms of the actual performance of the
economy in this period and achievements achievements in terms of policy
reforms actually implemented. implemented. The distinction is important
because dramatic policy changes in many countries have may not always
lead to actual comparable improvements in actual performance, as has happened
in many countries. Part 1 presents a summary assessment of of the paper
documents achievements in terms of the performance of the economy in the
post-reform period. Parts 2 and 3 attempt to evaluate the extent to which
the reforms were successful in bringing about policy changes. Part 2 focusses
on the achievement in reducing the fiscal deficit, which was a key macro-economic
policy objective and Part 3 reviews achievements in bringing about various
types of structural reforms. the cumulative change brought about over
seven years in each important policy area and identifies the unfinished
task in each case. Part 3 4 presents a summary assessment assessment of
achievements thus far and of the challenges that lie ahead.

1. Economic Performance
under the Reforms

To evaluate the impact of
the reforms on the performance of the economy it is useful to distinguish
between two periods. The first period is the three years 1991-92 to 1993-94
which were years of crisis management, when the primary objective of policy
was to stabilise the economy. The next four years 1994-95 to 1997-98 constitute
the post-stabilisation period, when the focus of policy was on the longer
term objective of putting the economy on a higher growth path. Since objectives
in the two periods were different, performance in each period must be
evaluated in terms of objectives of the period. The major parameters of
macro-economic performance the two periods are summarised in Table 1.

a] Crisis Management :
1991-92 to 1993-94

Indias performance
in stabilising the economy was commendable by any standards. The extent
of the achievement can be appreciated only if we recall the severity of
the crisis. The surge in oil prices triggered by the Gulf War in 1990
imposed a severe strain on a balance of payments already made fragile
by several years of large fiscal deficits and increasing external debt.
Coming at a time of internal political instability, the balance of payments
problem quickly ballooned into a crisis of confidence which intensified
in 1991 even though oil prices quickly returned to normal levels. There
was a flight of capital in the form of withdrawal of non-resident deposits
from the banking system and an unwillingness of international banks to
extend new loans. Foreign exchange reserves dropped to $1.2 billion in
June 1991, barely sufficient for two weeks of imports and a default on
external payments appeared imminent. The shortage of foreign exchange
forced tightening of import restrictions which in turn led to a fall in
industrial output. In November 1991, the gGovernment entered into a stand-by
arrangement under which the IMF would provide $ __2.3 billion over a two
year period and there was a definite expectation on both sides that the
stand-by arrangement may need to be followed by recourse to the ESAF facility
because adjustment was expected to take longer than two years.

Performance in the next two
years, measured in terms of the usual parameters of growth and stability
clearly exceeded expectations (Table 1). The current account deficit,
which had expanded to 3.2% of GDP in 1990-91, was brought down to a comfortable
level of 0.4% in 1993-94. Foreign exchange reserves were rebuilt to a
respectable level of 8.6 months of imports by the end of 1993-94. Inflation,
which had reached 13.7% in 1991-92, declined to 8.4% in 1993-94. Contrary
to the original expectations, there was no need to negotiate further access
to IMF resources at the end of the stand-by arrangement in November 1993.
Most important of all, and in sharp contrast to stabilisation programmes
in many other countries, there was minimal disruption of growth. The rate
of growth of GDP had collapsed to 0.8% in 1991-92 but it rebounded to
a near normal 5.3% in 1992-93, and then accelerated to 6.2% in 1993-94.

A common concern about macro-economic
stabilisation programmes is that they may hurt the poorer sections of
the population because of temporary reductions in employment resulting
from demand restraining policies, or even permanent loss of employment
in certain areas because of structural change. This aspect of performance
in the stabilisation period has been examined in detail by Tendulkar (1997).
Tendulkars estimates (Table 2) indicate that the incidence of both
rural and urban poverty declined more or less steadily through the 1980s
but this trend was briefly reversed in the early years of the reforms.
Restricting the analysis to estimates of poverty based on consumption
data for a full twelve month period, we can compare 1990-91 (July-June)
with 1992 (January-December) and this comparison shows an increase in
poverty in both urban and rural areas in the first two years of the reforms.
However, this deterioration in the poverty indicators was reversed in
1993-94 (July-June). In the case of urban poverty the reversal was complete
and the incidence of poverty in 1993-94 was actually lower than in 1990-91
but in the case of rural poverty it was marginally higher.

Tendulkar addresses the issue
of whether the increase in poverty was in any sense caused by the reforms
and also the related issue of whether it could have been avoided by following
a different set of policies. He explains the increase in poverty in 1992,
especially in rural areas, in terms of the decline in foodgrain production
in 1991-92 which lowered rural incomes generally and the associated increase
in food prices which lowered the real consumption levels of the poor in
both urban and rural areas. According to Tendulkar, the increase in food
prices was primarily the result of the fall in foodgrain production which
had nothing to do with the reforms though it was perhaps exacerbated by
the effect of the devaluation of the rupee in 1991, which increased the
import parity price, and therefore also the domestic market price, of
foodgrains.

It is difficult to determine
whether the increase in poverty could have been avoided by a different
mix of policy. One can postulate a counterfactual situation where this
is attempted by expanding the scale of income generating poverty alleviation
programmes, which would have raised incomes of the poor, or by expanding
the supply of subsidised foodgrains through the Public Distribution System
to moderate the rise in foodgrain prices for these years. However, both
options would have required additional budgetary expenditures which would
have been difficult to finance given the severe fiscal constraints affecting
the economy at the time. Expanding supplies through the PDS would also
have required additional imports of foodgrains to supplement domestic
availability and this would have required additional foreign exchange,
which was in short supply. All these considerations suggest that the measured
increase in poverty in the first two years of the reforms was largely
due to exogenous factors and was probably unavoidable given the severe
constraints on policy at the time. In any case it is important to note
that the deterioration was short-lived and was almost completely reversed
by 1993-94.

b] Post-Stabilisation
Period 1994-95 to 1997-98

The aim of policy in the
post-stabilisation period was to achieve a sustainable acceleration in
growth and here too the results were impressive. GDP grew at an average
rate of 7.5% in the three years 1994-95 to 1996-97, before slowing down
to 5.1% in 1997-98. The slow-down in 1997-98 is a matter for concern -
and we will return to this issue later in this paper - but it is important
to note that despite the slowdown the average growth rate in the four
years 1994-95 to 1997-98 was 6.9%, significantly higher than the growth
rate of 5.6% achieved in the 1980s. Four years is not a long enough period
to claim that the economy has been firmly put on a sustainable 7% growth
path, but there is little doubt that growth in the post-reform period
was faster than in the pre-reform years. It was also faster than targeted.
The growth rate achieved in the Eighth Plan period 1992-93 to 1996-97
was 6.8%, exceeding the Plan target of 6.5%.

Indias growth in the
post-reform period also compares favourably with the performance of other
developing countries. As shown in Table 3, Indias post-reforms growth
rate was higher than the growth of all developing countries taken together.
Comparing India with the twelve largest developing countries, we find
that China, Indonesia, Malaysia, Thailand and Chile grew faster than India
in the post-reform period while India grew faster than the other seven.

An encouraging aspect of
Indias experience is the behaviour of investment in the post-reforms
period. Latin American countries undertaking economic reforms in the 1980s
experienced a sharp decline in public investment without a compensating
acceleration in private investment with the result that the rate of investment
in many of these countries declined significantly and stayed depressed
for a long period. In India too, fiscal discipline did lead to a decline
in public sector investment as a percentage of GDP in the post-reform
period, but this was offset by an increase in private investment in both
the corporate and the household sectors (Table 4). Total investment as
a per cent of GDP therefore did not decline compared to the pre-reform
period and by 1995-96 it had actually increased to levels higher than
before the reforms. However, it is important to note that the rate of
investment in the later years increased only modestly and the average
rate of investment in the post-reforms period is only marginally higher
than in the pre-reform years. The fact that GDP growth accelerated significantly
after the reforms even though the investment rate was only marginally
higher suggests that productivity growth was higher - precisely the outcome
one would expect from efficiency oriented structural reforms.

Inadequate public investment
in the post-reform period had an adverse impact on the economy in one
respect. It led to serious under-investment in critical infrastructure
sectors such as electric power generation, roads, railways and ports.
The addition to power ggeneration capacity in the public sector during
the Eighth Plan was only a little over half the target and there were
similar shortfalls in capacity creation in roads and ports. These shortfalls
would not have mattered if capacity in the private sector had expanded,
but this did not happen either. The end result was that total investment
in infrastructure development was less than it should have been, leading
to large infrastructure gaps These inadequacies did not come in the way
of achieving higher economic growth in the post reform years because there
was some slack in the system, but there can be no doubt that rapid growth
will be difficult to sustain in future unless investment in infrastructure
can be greatly expanded.

The high growth of the post-reform
period was also accompanied by an improvement in the external payments
position. The current account deficit has varied between 1% and 1.8% of
GDP and foreign exchange reserves have been comfortable throughout. Exports
grew strongly for three years after 1992-93, averaging 20% dollar growth
per year between 1993-94 and 1995-96, but then slowed down sharply in
1996-97 and yet again in 1997-98 (Table 1). This deceleration in exports
is in part a reflection of slower growth in world trade in 1996 and 1997
measured in US dollars but even so, it is a matter of deep concern for
the future. Indias external debt indicators improved continuously
in the post reforms period. The debt service ratio had reached a worrying
level of 35.3% in 1990-91 but it declined to 18.3% in 1997-98 (Table 1).
Other indicators such as the debt to GDP ratio, and the debt to exports
ratio, also show substantial improvement.

Unfortunately, it is not
possible to provide reliable answers No definitive answer can be given
to the all important question of what happened to poverty in the post-stabilisation
period since no poverty . The latest available estimate of poverty is
for 1993is available after 1993-94. and the next available estimate will
be for 1996-97. We know from past experience that there was no significant
trend in poverty from the mid-fifties to the late seventies when per capita
income grew at very low rates but this changed after the late 1970s as
growth rates accelerated, leading to a steady though not dramatic decline
in poverty. Projecting on thise basis, of this relationship the acceleration
in growth after 1993-94 must have led to a resumption in the declining
trend of poverty in the post stabilisation period but in the absence of
survey data this is at best a plausible projection. Data on social indicators
such as life expectancy and infant mortality, also provide some indication
of the living standards of the poor and the information available is summarised
in Table 1. T. As shown in Table 1hese indicators show continuing improvement
in the post reform years which is consistent with the hypothesis of a
continuing decline in poverty after 1993-94. However, these positive indicators
notwithstanding, it remains trueThe weight of evidence therefore suggests
that after a brief deterioration in poverty in the initial years which
was quickly reversed, there was probably a resumption of the trend of
steady improvement observed in the previous decade. that progress in reducing
poverty in India is much less impressive than witnessed in East and South
East Asia in the seventies and eighties. Replication of such success would
provide a much more powerful constituency in favour of reforms then has
been the case thus far. This calls for more rapid rates of growth than
have been witnessed in India thus far, sustained over a longer period
and also a stronger effort at improving social development through purposive
government action.

focus The slowdown in GDP
growth witnessed in 1997-98 is a worrying feature of the post-stabilisation
period. As noted above, GDP the average rate of growth in the post-reforms
period remains at a respectable level even after we include the slowdown.
including the slower growth in 1997-98, but this raises the question it
is certainly relevant to ask whether 1997-98 was a purely temporary downturn
or whether it reflects the restraining impact of specific constraints
which, if not tackled urgently, could force a return to a lower growth
path. This issue is examined in Part 4.

2. POLICY CHANGES UNDER
THE Macro Economic Balance and the Fiscal Deficit REFORMS

18. The gradualist pace of
Indias reform has at times made the reforms appear halting and even
confused at a given point in time, but even a gradualist process can bring
about a significant cumulative change over seven years. The focus of this
section is to assess the cumulative change actually brought about in some
of the important areas of policy reform.

a] Reducing the Fiscal
Deficit

High fiscal deficits in the
1980s were one of the root causes of the crisis of 1991 and reducing the
fiscal deficit was therefore a critical macro-economic objective a key
objective not only of Indias reforms. This was particularly important
in the initial years, when the country was subject to the discipline of
an IMF programme in which fiscal deficit reduction was a key component.
Ialso over the medium term as an instrument for t was also important in
the medium term as a means of reducing real rates of interest in the economy
and creating conditions in which private investment would expand rapidly.

There was encouraging progress
at the start of the reforms, when the fiscal deficit was reduced from
8.3% of GDP in 1990-91 to 5.9% in 1991-92, but performance thereafter
was disappointing. As shown in Table 1, the deficit declined only marginally
in 1992-93 and then increased to 7.4% in 1993-94. It declined again thereafter,
but remained well above the Finance Ministrys medium term target.
In 1993 the Ministry had projected a fiscal deficit target of 3% by 1996-97.
At one stage, it was envisaged that the fiscal deficit would be reduced
The actual fiscal deficit in 1996-97 was 5.3 per cent of GDP, more than
2 percentage points higher than the target, and it deteriorated further
to 6.1% in 1997-98. These figures refer only to the Central Government
fiscal deficit. If the deficit of the State Governments is added the combined
fiscal deficit of the Centre and States was around 7.5% in 1997-98 which
is much higher than in most other developing countries.

The inability to reduce the
fiscal deficit in line with expectations is one of the most disappointing
aspects of Indias reforms. Some indication of what went wrong can
be gleaned from the trends in revenues and expenditures summarised in
Table 5. The sharp reduction in the fiscal deficit in 1991-92 was achieved
through a combination of a significant decline in expenditure as a percentage
of GDP and a marginal increase in revenues. Total expenditure continued
to decline as a percentage of GDP in subsequent years but total revenues
also declined. It The lack of buoyancy in revenues was the principal reason
why the fiscal deficit could not be reduced. The scope for reducing the
deficit in future depends upon the scope for reducing expenditures or
increasing revenues as a percentage of GDP.

a. The scope for reducing
expenditure

It is tempting to conclude
that further reduction in expenditure as a percentage of GDP should be
attempted to reduce fiscal deficits in future. However, the scope for
reducing expenditure should not be overstated. As shown in Table 5, all
items of expenditure except interest payments already show a steady decline
steadily as a percentage of GDP in the post-reforms period. On the face
of it therefore the fiscal problems of the economy are not due to unbridled
growth of public expenditure. In fact many would argue that India needs
much larger volumes of public expenditure in health, education and other
social sectors to close the gaps which exist at present between India
and other Asian countries. It is now widely recognised that closing these
gaps is essential not only as part of the strategy for poverty reduction,
but also as an essential precondition for transiting to an employment
generating high growth path. Apart from expenditure in the social sectors,
there is also a need for larger expenditure in certain types of economic
infrastructure, especially in rural areas, which may not be commercially
viable and can only be financed through the Budget.

In order to expand expenditure
in these areas it is necessary to reduce expenditure in other areas so
that total expenditures as a percentage of GDP are kept under control.
This calls for a thorough review of government expenditures and staffing
patterns to bring about operational economies, discontinue less important
programmes and reduce inefficiently targeted subsidies. There is also
a very strong case for reducing the size of the what is clearly a bloated
bureaucracy. Expenditure reduction is therefore critical for fiscal management
but more to provide room for other expenditures to expand, than to bring
about a reduction in total expenditure as a percentage of GDP. These limitations
on our ability to reduce total expenditure as a percentage of GDP underscore
the role of revenue buoyancy as the principal means of reducing fiscal
deficits in future.

b. The need for buoyant
tax revenues

A reduction in the As shown
in Table 5, tax revenues flowing into the Central Budget actually declined
as a percentage of GDP in the first three years of the reforms. The declining
trend was reversed after 1993-94 but even so, tax revenues in 1997-98
as a percentage of GDP were about 0.5 percentage points below the pre-reform
level whereas they should have been 1.5 percentage points higher. This
decline in the tax ratio points to serious weaknesses in the tax system
despite extensive reform of both direct and indirect taxes undertaken
as part of the reform programme. Indias tax reforms were based on
the Reports of Tax Reforms Committee (Chelliah Committee) appointed in
1991 and aimed at simplifying the tax structure, moving to moderate rates
of tax in line with trends in other countries, and relying upon base broadening
and improved tax administration to yield strong revenue growth. It is
important to consider why revenue buoyancy has been inadequate despite
these reforms.

In the area of direct taxes
the reforms have succeeded in establishing a regime of moderate tax rates
which compare reasonably well with other countries. 23. The maximum rate
of personal income tax has come down from 56% at the start of the reform
to 30% in 1997-98. The rate of corporation tax on Indian companies, which
varied from 51.75% to 57.5% in 1991-92, depending upon the nature of the
company, has been unified and reduced to 35%. Despite these reductions
in rates, revenues from personal and corporate taxes have remained buoyant
as indicated by the continuing increase in these revenues as a per cent
of GDP (Table 6). The share of direct taxes in GDP is still too low, but
it has increased steadily over time from 2% in 1990-91 to 3.5% in 1997-98.
On the whole, this appears to be an area where the strategy of reform
seems to be working fairly well and needs to be continued, with special
emphasis on broadening the tax base and improving compliance by reducing
under-reporting of taxable income.

24. Customs revenues declined
steadily as a percentage of GDP in the initial years and then stabilised
at a lower level. In view of the explicit intention The maximum rate which
was as high as 250% before the reforms, has been reduced to 40% in 1997-98,
and duty rates below the maximum have also been reduced and rationalised.
of reducing levels of protection in the economy, the loss of revenue from
customs duties is not unexpected and should be viewed as an acceptable
cost of tariff reforms. As argued later in this paper, customs duty rates
have to fall further in future, which implies that this cannot be a source
of increasing the tax ratio in the years ahead. At best we can hope to
avoid a further decline in the ratio of custom duties to GDP despite a
continuing decline in duty rates because the removal of quantitative restrictions
on consumer goods, which is a part of the reform agenda, will add to the
buoyancy of customs revenues as these imports are likely to be at the
upper end of the duty rate structure.

25. There has been less change
in the tax structure in the case of excise duties thoughExcise duties
are a major source of indirect tax revenue in India and performance in
this area has been unexpectedly weak. Excise duties as a percentage of
GDP declined from 4.4% of GDP in 1990-91 to 3.4% in 1997-98. Had the tax
ratio increased over this period, as it should have in view of the fact
that the industrial sector, which is the base of excise duties has grown
faster than GDP, the fiscal deficit would have been significantly lower.
The reasons for the poor performance of excise duties need to be carefully
studied so that corrective action can be taken.

Ideally, the domestic indirect
tax system should have been converted into a full fledged VAT which integrates
the tax system from manufacturing down to retail sales, creating a self
re-inforcing chain of tax compliance. Experience in other countries shows
that a shift to VAT would help improve revenue generation but this is
not possible in India under the present constitutional division of powers,
whereby excise duties at the production stage are levied by the Central
Government while sales taxes at the wholesale or retail level are levied
by the States. In the absence of VAT, India had introduced a modified
VAT (called Modvat) under which credit was given for excise taxes paid
on inputs against excise taxes due on outputs. thus avoid cascading of
excise duties. This system was extended and rationalised during the reforms
in various ways. The number of duty rates has been reduced and some exemptions
removed. The tax credit facility (Modvat facility) was earlier not available
for all products and is now almost has now been made almost universal
in coverage. Earlier, credit was given only for duties paid on inputs
but since 1995 it has been extended to duties paid on capital goods. The
number of duty rates has been reduced and some exemptions removed. These
efforts at rationalising the excise duty structure were expected to lead
to a rising share in the ratio of excise revenue to GDP but in fact excise
revenues have declined steadily.

It is possible that expansion
of the Modvat facility to all goods, including capital goods, as part
of the tax reforms was not accompanied by a sufficient increase in excise
duty rates on final products to maintain revenue buoyancy. In a system
with full tax credit being given for all inputs and for capital goods,
excise revenue mobilisation (net of Modvat credit) depends upon the revenue
realisation from excise duties on final consumption. Unfortunately, Indias
excise duty structure contains too many consumer products which are either
exempted from excise altogether or attract relatively low rates of duty.
Tax reformers usually recommend a tax structure characterised by a single
duty rate, with additional duties to be levied on luxury items, as most
likely to improve tax compliance and to increase revenues Even if a single
rate proves difficult to implement immediately, it is desirable to move
to a rate structure with at most three rates as soon as possible. However,
this implies an increase in excise duty rates for a large number of currently
low taxed consumer items. It is necessary to create public awareness that
across the board increases of this sort, implemented as part of a strategy
of rationalisation in which other tax rate are reduced, does not increase
the burden of taxation on the average commoner.

3. Structural Reforms

Indias efforts at structural
reforms covered the familiar gamut of decontrol of private investment,
opening up the economy to foreign trade and foreign investment, financial
sector reforms, etc. This familiar package of market oriented reforms
was supplemented by efforts to strengthen various anti-poverty programmes
reflecting a widely shared perception that liberalisation by itself would
not provide an adequate flow of benefits to the poorest sections of the
population at least in the short run. In this section we evaluate the
extent of change actually implemented in the critical areas of structural
reform, indicating the degree of consensus on each of these issues across
the political spectrum. Multifaceted reforms also raise issues of sequencing
because the effectiveness of reforms in one area depends upon the implementation
of reforms in other areas. We touch upon these issues where they are especially
important, or have been the focus of public debate.

a] Removing Controls on
Private Investment

Indias industrial environment
before the reforms was characterised by pervasive government controls
on private investment which prevented entrepreneurs from responding quickly
and flexibly to market signals. Reducing these controls was essential
to create a more competitive industrial environment and this part of the
reform agenda - broadly described as domestic liberalisation - . This
aspect of the reforms enjoys the widest possible political support across
parties. Major progress has been made in this area as far as Central Government
controls are concerned.

Industrial licensing was
a major instrument of control under which Central Government permission
was needed for both investment in new units (beyond a relatively low threshold)
and also for substantial expansion of capacity in existing units. Licensing
was undoubtedly responsible for many of the inefficiencies plaguing Indian
industry. In a series of steps, licensing was abolished for all except
6 industries viz. alcoholic beverages, cigars and cigarettes, electronics,
aerospace and defence products, hazardous chemicals and pharmaceuticals.
Another major achievement was the abolition of the special permission
needed under the MRTP Act for any investment by the so-called "large
houses". This was an additional instrument of control over large
private companies or companies belonging to large groups, in addition
to industrial licensing. Its stated objective was to prevent "concentration
of economic power" but in practice it only served as another barrier
to entry, reducing potential competition in the system. Abolition of these
controls has given Indian industry much greater freedom and flexibility
to expand existing capacity, or to set up new units in a location of their
choice, thus increasing the pressure of competition as well as the ability
to face competition.

Major progress has also been
made in opening up areas earlier reserved for the public sector. At the
start of the reforms 18 important industries, including iron and steel,
heavy plant and machinery, telecommunications and telecom equipment, mineral
oils, mining of various ores, air transport services, and electricity
generation and distribution, were reserved for the public sector. This
list has been reduced to 6, covering industries as arms and ammunition,
atomic energy, mineral oils, atomic minerals and railway transport. Because
of this liberalisation, private investment including foreign investment
has flowed into areas such as steel, telephone services, telecommunications
equipment, electricity generation, petroleum etelecommunications equipment,
electricity generation, petroleum exploration development and refining,
coal mining and air transport, none of which would have been possible
earlier because of public sector reservation.

An important area where decontrol
domestic liberalisation has made very little progress is relates to the
the policy of reserving certain items for production in the small scale
sector defined in terms of a maximum permissible value of investment in
plant and equipment. The policy "protects" small scale units
by barring the entry of larger units into reserved areas also prevents
existing small scale units from expanding beyond the maximum permissible
value of investment. India is unique in adopting reservation as an instrument
for promoting small scale producers and Thethe policy obviously entails
efficiency losses and imposes costs on consumers. Several committees have
recommended various degrees of dilution of the reservation policy. Most
recently, an Expert Committee on Small Enterprises set up in 1995, has
recommended that reservation should be completely abolished and efforts
to support small scale producers should focus instead on positive incentives
and support measures. None of the governments in the post-reforms period
has been inclined to accept a drastic re-orientation of policy along these
lines. The United Front Government in 1997 mitigated the rigours of reservation
by raising the investment limit for small scale industries from Rs.60
lakhs to Rs.3 crores. It also removed 15 items from the reserved list.
The successor BJP led government has announced the de-reservationed of
farm implements in 1998.

Many of the items on the
reserved list are such as would in any case be produced in the small scale
sector so that reservation does not impose significant cost on the economy.
However, a reconsideration of the reservation policy is urgently needed
in areas such as garments, toys, shoes and leather products. These are
areas with a large export potential but reservation prevents the development
of domestic units of the size and technology level which can deliver the
volumes and quality needed in world markets. Some flexibility was introduced
in 1997 ______ by allowing larger units to be set up in these sectors
provided they accept an obligation to export 50% of production. It remains
to be seen whether this modification will provide sufficient incentive
to encourage producers to set up larger capacities to tap export markets.

While Central Government
controls on investment have been greatly liberalised except in the matter
of small scale reservation, little has been done about controls at the
State level. Investors typically complain of having to obtain a very large
number of separate state government approvals relating to acquisition
of land, electricity and water connections, conformity with regulations
regarding facilities to be provided for labour, various safety and pollution
related clearances etc. These controls generate harassment, delays and
petty corruption and are viewed as major impediments by both domestic
and foreign investors. Reforms to eliminate unnecessary controls at the
State level are urgently needed to complement decontrol at the Central
level. Some State Governments are trying to streamline the system, and
these efforts are being spurred by the growing competition among States
to attract both domestic and foreign investment. However the situation
varies from State to State and much more needs to be done in this area.

b] Opening the Economy
to Foreign Trade

Opening the economy to trade
and foreign investment was an important objective of the reforms aimed
at reaping the potential benefits from greater integration with the world
economy. Unlike the effort to reduce controls on domestic industry, which
enjoyed wide support, for which there is widespread support, there was
less consensus on external liberalisation. Spokesmen for Indian industry
initially voiced strong support for both domestic liberalisation and external
liberalisation, especially liberalisation of access to imports of components
and capital goods. As tariff levels came down and the pressure of competition
from imports increased, concern began to be expressed about the need to
provide an adequate transition period for domestic industry to adjust
to external liberalisation, in particular the need to create a "level
playing field" by first removing domestic policy constraints afflicting
domestic firms, which made it difficult for these firms to become competitive.
This was sometimes expressed as an issue of sequencing, in which it was
argued that domestic liberalisation must precede external liberalisation.
While the debate on these issues continues, a . Despite these doubts a
substantial consensus of sorts has evolved in favour of a gradualist process
of external liberalisation. Significant progress has been made towards
this objective over the past seven years. by removing quantitative restrictions
and lowering tariff barriers, though the process is not yet complete.
.

i] Dismantling Quantitative
Restrictions

Indias trade policy
regime before the reforms was heavily dependent upon the use of quantitative
restrictions(QRs) in the form of import licenses, more than almost any
other developing country. Imports of finished consumer goods were simply
not allowed and even inputs into production such as raw materials, components
and capital goods were subject to restrictions through import licensing.
The system began to be administered more liberally in the 1980s, with
import licenses being much more freely given, but it remained restrictive
and also highly discretionary. The first phase of dismantling QRs occurred
in the first two years of the reforms when import licensing was virtually
abolished for imports of industrial raw materials, intermediates, components
and capital goods. By 1993, these categories could be imported freely,
subject only to the prevailing tariff levels. However, agricultural products
and industrial consumer goods remained subject to import controls. Import
restrictions on agriculture were probably redundant as Indias agricultural
product prices were typically lower than import prices and agriculture
actually suffered from negative protection via export controls. Restrictions
on imports of consumer goods on the other hand provided substantial and
open ended protection for all industrial consumer goods , which account
for about 25 per cent of the manufacturing sector in terms of value added.

Continuing with near infinite
protection for consumer goods while liberalising other imports has been
widely criticised as illogical because it only distorts resource allocation
in favour of highly protected consumer goods industries and away from
basic and capital goods industries which are otherwise thought to be "strategically"
important. This was recognised at a policy level and the need to extend
import liberalisation to consumer goods as part of the reforms was explicitly
stated in the Eighth Plan as early as 1992, but implementation of this
element of trade policy has been very slow because of perceived political
sensitivity. Predictably once the balance of payments improved, the QR
regime was challenged by Indias major trading partners as inconsistent
with the WTO. This led to protracted negotiations which culminated in
the United Front announcing, in 1998, a plan to phase out QRs on all imports
within a period of six years. This was accepted by all the major trading
partners except the US. The phase out will occur in three stages with
most QRs being phased out in the first 3 years while QRs on agricultural
products will be phased out only at the end of the period. The commitment
to phase out QRs has been endorsed by the BJP Government which took the
first step in thuethe process by removing QRs on 350 items in April 1998.
This still leaves about 2200 items subject to QRs to be removed over the
next six years. In August 1998, the government unilaterally removed QRs
on 2000 of these items for imports from the SAARC region countries in
order to give a boost to trade liberalisation in the region.

ii] Reducing Tariffs

Indias trade policy
before import duties before the reforms was characterised by import tariffs
which were among the highest in the world. Rates with duty rates above
200% were being fairly common. Significant progress has been made in reducing
tariff rates since then. The maximum tariff rate was brought down in a
series of steps to 45% in 1997-98 (Table 7). Tariff rates below the maximum
have also been lowered over the years, bringing the import weighted average
tariff rate for all products down from 87% in 1990-91 to 30% in 1998-99.

Customs duties were steadily
reduced in the first five years. Duties continued to be lowered on a number
of items in 1996 and 1997 but this was offset to some extent by the imposition
of a 2% surcharge on most imports in 1996, as a revenue raising measure,
followed by another 3% surcharge in 1997 to finance the burden of the
large civil service pay rise announced in that year. The Budget for 1998-99,
presented by the new BJP Government, introduced some changes in customs
duties an entirely new special customs duty. Several industry associations
had complained of the lack of a level playing field on the grounds had
complained that domestic producers were subject to certain local taxes,
which were not balanced by equivalent taxes on imports in the same way
as excise duties on domestic production are balanced by an equivalent
"countervailing duty" duties levied on imports. It was argued
that these local taxes had the effect of reducing the protective element
in the existing duty structure, and in certain cases where customs duties
were low, the erosion was said to result in a complete elimination of
protection. Responding to these demands, a special additional duty on
imports to balance the incidence of local taxes was levied initially at
8% but quickly reduced to 4%. This duty was widely criticised as signalling
a retreat into protectionism, a charge vociferously denied by the government
which pointed to the fact that the 1998-99 Budget also reduced customs
duties on a number of products, and in this respect continued the trend
of tariff reduction of earlier yearswhich indicates.also The deadline
for zero duty treatment of a number of electronic products, agreed to
under the Information Technology Agreement-1, was also advanced by two
years, which indicates signalling an acceleration of the process of opening
up in this area.

Despite the new duties introduced
in the past two years, the average rate of duty is much lower than in
1990-91 (Table 7). However, average tariff levels in India are much higher
than in other developing countries, where tariff rates typically range
between 5 and 15%. Since consumer goods continue to be protected by QRs,
the tariff levels understate the degree of protection for these items.
The process of reducing tariff levels clearly needs to continue to complete
the reform process in this area.

Tariff reform in future must
also focus on the problem of tariff inversions, whereby duties on final
products are lower than duties on inputs thus giving rise to very low
or even negative protection in some cases. The duty on various types of
steel for example is 30 to 35% whereas the duty on capital goods ranges
from 20 to 25% and is even zero in some cases. Such tariff inversions
did not matter the earlier system because of quantitative restrictions
on imports of the final product but they obviously become very important
once QRs are phased out. The problem has arisen in part because tariffs
on many intermediate inputs were relatively high to begin with and the
gradualist pace of reduction has left many of these tariffs at too high
a level, while other tariffs have been reduced more rapidly.

There is also a case for
a pre-announced time table for future tariff reductions. The Congress
Government had indicated that tariffs would be brought down to levels
"comparable with other developing countries" but had not specified
either the final structure of tariffs or the time frame for reaching it.
The United Front government stated that it would move to Asian levels
of tariffs by the year 2000 but the exact tariff structure was left undefined
except in the case of hydrocarbons where a terminal year structure for
2002 has been indicated and for information technology related products
where India has accepted the ITA-1 commitments. The BJP led government
has stated that it favours "calibrated globalisation" which
implies that the process of reducing tariffs will continue, but again
no specific time frame has been spelt out. A clearer indication of target
levels of tariffs over the next three to five years would help investors
making decisions on new investments.

To summarise, Indias
tariff reduction programme, though still incomplete, has certainly created
a more open economy, with significant beneficial effects as Indian firms
are being pushed to restructure their operations to become more competitive.
The fact that protectionist noises from some segments of industry, have
increased in recent years indicates that this process is beginning to
bite. Banks and financial institutions are also increasingly assessing
the viability of new projects on the basis that the economy will continue
to open up and tariffs will be reduced further. The pace of the transition
has been slow, consistent with the gradualist strategy, and it is necessary
to continue lowering tariffs, focussing especially on tariff inversion
problems. Fortunately the present levels of duty are now in the range
where the remaining adjustment can be completed in two or three years.

iii] Exchange Rate Flexibility

The removal of QRs and reduction
in tariff levels described above would not have been possible but for
parallel changes in exchange rate policy. The rupee was devalued in July
1991 by 24% as part of the initial stabilisation programme, and a dual
exchange rate was introduced in March 1992. The dual exchange rate was
unified shortly thereafter in March 1993 and the unified rate was allowed
to float. The cumulative effect of these changes was that between June
1991 and March 1993 the exchange rate depreciated from $1=Rs.20 to $1=Rs.31,
a depreciation of 35% in the dollar value of the rupee and a real depreciation
(adjusting for price changes) of around 27% vis-à-vis Indias major
trading partners. This adjustment in the exchange rate clearly helped
Indian industry to meet the import competition resulting from trade liberalisation.

The flexible exchange rate
regime has worked reasonably well with the exchange rate responding to
market conditions while the Reserve Bank of India (RBI) intervenes periodically
through foreign exchange sales and purchases or through monetary fine
tuning to "maintain orderly market conditions". Exchange rate
management has avoided the danger of excessive rigidity and also the opposite
dangers of overshooting with associated loss of confidence. Although there
is no declared real effective exchange rate target the system has worked
in a manner to preserve the advantageous real exchange rate achieved in
the early years of the reforms. As shown in Figure 1, the real exchange
rate depreciated sharply at the start of the reforms, and appreciated
thereafter in 1994-95 and 1995-96, but this appreciation in the real exchange
rate was corrected in subsequent years, bringing the real effective rate
close to the level reached in 1993-94.

As part of the process of
transiting to an open economy India declared full current account convertibility
in 1994 and accepted the corresponding obligations of Article VIII of
the IMF. Following this decision a number of steps have been taken to
liberalise exchange restrictions on current account transactions. The
United Front government in 1997 announced that the Foreign Exchange Regulation
Act of 1973 would be repealed and replaced by a more modern Foreign Exchange
Management Act (FEMA) but the Government fell before this could be done.
It is a measure of the continuity in policy that FEMA was subsequently
introduced in 1998 by the successor BJP led coalition.

c] Policy towards Foreign
Investment

The reforms involved a radical
re-orientation of foreign investment policy with foreign investment being
actively sought not only as a preferred means of financing balance of
payments deficits compared with external borrowing, but also because it
provides access to closely held technology and to global marketing linkages.
Both foreign direct investment (FDI) and portfolio flows have been encouraged
in the post-reform period with good positive results in both cases.

The process of approving
foreign direct investment (FDI) was expedited by providing a window of
automatic approval of FDI upto 51% foreign equity in a defined list of
48 industries and upto 74% for 9 high priority industries. Foreign investment
proposals which are not eligible for the automatic route can obtain approval
from an inter-Ministerial body called the Foreign Investment Promotion
Board (FIPB). Approvals from FIPB are generally seen to have been speedily
and liberally given. Despite widespread concerns about the BJPs
attitude to foreign investment, the new government has continued this
system and has announced its intention to expedite clearances and also
set up mechanisms to help translate approvals into actual investment decisions.

The results achieved by the
new policy are summarised in Table 8. Total approvals for FDI have increased
from $325 million in 1991-92 to $16 billion in 1997-098. Actual inflows
are running atof course much lower, level reflecting the lag in converting
approvals between approvals andto inflows, but even these have increased
from a negligible level of $133 million in 1991-92 to over $3 billion
in 1997-98. This may not appear impressive compared to the volumes attracted
by many other countries, but it represents a dramatic increase from the
earlier levels prevailing earlier and it is growing. The change in the
foreign investment environment in India is reflected in the fact that
a large number of Indian companies have sought foreign joint venture partners
while major foreign investors have focussed on India for the first time.
The latter category includes several of the Fortune 500 companies such
as General Motors, Ford, Merck, Sony, Honda Motor, Coca Cola, Hewlett
Packard, Texas Instruments, LG International, Fanuc, Samsung, Du Pont,
AT and T, BT, Enron, Shell and a host of others. The amounts invested
in most cases are as yet small, but the entry of such investors holds
out the potential for substantially larger inflows in the years ahead.

The economy has also been
was also opened to portfolio investment in two ways. In 1993 Foreign Institutional
Investors (FIIs) meeting certain minimum standards were allowed to invest
in Indian equity and later also in debt instruments through secondary
market purchases in the stock market. At present 528 FIIs are registered
with the Securities and Exchange Board of India (SEBI) and around 150
are active investors. A second window for portfolio investment was provided
by allowing Indian companies to issue fresh equity abroad through the
mechanism of Global Depository Receipts (GDRs). This enabled Indian companies
to raise resources from passive investors in world markets instead of
seeking active investors as is the case with joint venture partners. Portfolio
investment has expanded rapidly in the post-reform period. From a level
of $ 4 million in 1991 the inflow on account of FII flows and GDRs taken
together quickly increased to $3.6 billion in 1993-94 and fluctuated thereafter.
It declined to $1.5 billion in 1997-98 reflecting the effect of the Asian
crisis on capital flows to emerging markets. Despite the often expressed
concern about the volatility and unreliability of portfolio capital flows,
Indias experience in this area has been fairly encouraging. Inflows
of portfolio capital have fluctuated but they did not turn negative even
in 1997-98 during the East Asian crisis. The cumulative inflow of portfolio
capital since the reforms began exceeds $15 billion, a significant amount
in absolute terms even if it is associated with some potential for volatility.

While liberalising inflows
of FDI and portfolio capital, other elements of the capital account remained
subject to controls though the controls were more flexibly administered.
Corporations and individuals need government permission to borrow abroad
and such permission is granted within a framework which places a cap on
total external borrowing and also ensures a minimum maturity period for
each borrowing. This policy has helped to control Indias exposure
to external debt and in particular to avoid a build up of short term debt
which is viewed with particular disfavour in financial circles in the
aftermath of the Asian crisis. Foreign investors are allowed to repatriate
dividends and capital freely but Indian residents are restricted from
taking capital out of the country, a restriction which makes it easier
to avoid panic over-reaction in foreign exchange markets.

In 1996, the government appointed
a Committee on Capital Account Convertibility to advise on the transition
to full capital account convertibility. The Committee recommended moving
to capital account convertibility over time in a phased manner, but emphasised
that certain pre-conditions must be established first. These include a
moderation in the rate of inflation, a reduction in the fiscal deficit
to 3%, and also considerable strengthening of the domestic banking system
to deal with stresses created by an open capital account. These conditions
implicitly rule out any quick move to capital account convertibility.
The recent East Asian experience certainly suggests that there is merit
in a cautious approach in this area.

d] Reducing Price Controls

Reduction, if not elimination,
of price controls is a familiar component of market oriented reforms everywhere
and this was the case in India also. Price control was abolished at an
early stage of the reforms in some key industries, viz., iron and steel,
coal, phosphatic and potassic fertilisers, newsprint, naphtha, lubricating
oils and molasses .Price control on pharmaceuticals was not
abolished but its coverage was reduced in 1995 from 143 basic drugs to
76. However, price control remains in place in three major areas, i.e.,
hydrocarbons, electricity and nitrogenous fertilisers, introducing significant
distortions in the system. Interestingly though price decontrol is clearly
a part of domestic liberalisation which enjoys wide support in principle,
there is great reluctance across all parties to implement it in practice.

i] Decontrol of Hydrocarbon
Prices

The petroleum sector in India
was fully state owned at the start of the reforms with the State also
controlling imports of crude oil and production. Prices were determined
by a complex Administered Price Mechanism (APM) under which domestic producers
of crude and natural gas were paid controlled prices which were much lower
than world market prices. Refineries also received controlled prices for
their products based on the cost of crude oil supplied to them (either
underpriced domestic crude or market priced imported crude) plus a refining
margin for each refinery based on plant specific refining costs. Prices
charged to consumers were also controlled and were expected to cover the
cost of domestically produced and imported supplies. However, there was
substantial cross subsidisation across products, with kerosene and diesel
being underpriced, while gasoline and aviation fuel were over priced.
The inefficiencies in this system were extensive. Under-pricing of crude
oil discouraged exploration. Cost based product prices paid to refineries
gave them little incentive to reduce costs. Severe underpricing of kerosene
led to pervasive black marketing and adulteration of diesel with kerosene.
Since consumer prices were not adjusted sufficiently frequently to reflect
changes in the cost of imports, the system often generated deficits in
the oil sector accounts. The controlled price regime was particularly
unsuitable for attracting private investment in either production or refining
since private investors expected an assured structure of market related
prices.

In a major decontrol initiative
the United Front government in 1997 announced a phased de-regulation of
petroleum prices to be completed by 2002. The first step in 1997 was to
fix the domestic consumer prices of diesel, fuel oil and LSHS on the basis
of import parity, with monthly adjustments to reflect changes in import
prices. Domestic crude oil and natural gas prices, as well as petroleum
product prices paid to refineries, will be progressively adjusted within
an APM framework to reach import parity prices by the year 2002 at which
point they will be de-regulated. Import parity pricing for crude and products
is feasible only if the customs duty structure is rationalised to avoid
anomalies in the present structure where the customs duty on crude oil
is higher than on many products. The government has announced a duty rationalisation
and the year structure of customs duties in this sector to be achieved
by 2002 has been published, though the annual phasing to reach that level
has not been announced. Kerosene, which meets the fuel and lighting needs
of the poor, will continue to be subsidised, but this subsidy will be
made explicit and met from the Budget. Similarly naphtha, which at present
is supplied at a subsidised price to the fertiliser industry will be provided
only at the normal decontrolled price, requiring either an increase in
fertiliser prices or an increase in the fertiliser subsidy from the Budget.
The transfer of these subsidies to the Budget will impose a severe fiscal
burden but a successful transition to market prices in this important
sector will be a major achievement with significant efficiency gains.

ii] Control over Electricity
Prices

Pricing of electricity is
subject to regulatory control in most countries but the way it has operated
in India is seriously flawed. Electricity prices charged to consumers
are fixed by State Governments and have been set very low for certain
categories of consumers such as households and agricultural users and
this is one of the major reasons for the poor financial condition of the
State Electricity Boards (SEBs). The SEBs are expected to earn a rate
of return of 3% on capital employed but they actually earn a negative
rate of -13.7 per cent with total losses amounting to Rs.10,000 crores
or about 0.8 per cent of GDP. This is one of the main reasons why public
investment in this sector has fallen below target. It is also the reason
why it is difficult to encourage private investment in electricity generation
since private investors are deterred by high risks of non-payment by financially
weak SEBs which are the sole buyers.

A shift to a rational system
of setting electricity tariffs is essential if investment in power, whether
public or private, is to take place. The primary responsibility for such
reforms rests with the State Governments but the Central Government has
an important catalytic role to play. In 1995 the Congress Government announced
a National Minimum Action Plan for Power envisaging depoliticisation of
electricity tariffs by entrusting tariff fixation to an independent State
Regulatory Commission with terms of reference which would ensure that
tariffs must cover costs and earn a 3% return. The Plan also sought to
limit the extent of price distortion through cross subsidy by stipulating
that the maximum underpricing allowed to any category of consumer should
not exceed 50% of the cost of production nor should any consumer be charged
more than 50% above the cost of production. The successor United Front
Government introduced legislation to set up a Central Electricity Regulatory
Commission but was not able to get it passed by Parliament. The BJP government
in 1998 was able to get Parliamentary approval for a modified Central
Electricity Regulatory Commission Act which sets up a Central statutory
commission to regulate all inter-state sales and transmission of electricity
and set tariffs in such cases. The Act also provides for separate State
Regulatory Commissions to be set up by individual states which will regulate
the electricity sector within a State and fix all tariffs. Though the
establishment of State level Commissions is not mandatory it is heartening
to note that as many as ten States are expected to enact the necessary
legislation setting up State level commissions. Another important step
forward was the passage of the Electricity Transmission Act which opened
the transmission sector to private investment.

The process of reform in
the power sector has made good progress in some States. Orissa was the
first to restructure its power sector by setting up a State level regulatory
commission for fixing tariffs and ..
unbundling the monolithic SEB into separate generation, transmission and
distribution corporations. It is currently engaged in privatising distribution.
A few others, Andhra Pradesh, Haryana and Rajasthan are considering similar
reforms. It is difficult to say as yet how fast these changes will be
implemented in other States, but there is no doubt that the process has
begun.

iii] Price Controls
on Nitrogenous Fertiliser

Nitrogenous fertiliser is
another important industry where prices continue to be fully controlled.
Fertiliser factories are paid a cost based plant specific producer price,
and the government fixes a low consumer price for farmers. The difference
between producer and consumer prices is met by a budgetary subsidy which
amounts to about 0.7% of GDP. The inefficiencies of the system have been
noted by many critics. The cost based producer price system provides insufficient
incentive for cost reduction and under pricing of nitrogenous fertilisers
for farmers is leading to wasteful use of fertilisers and a distortion
in the N:P:K ratio compared to the agronomically recommended norm. The
resources absorbed by the subsidy have also increased consistently over
time and it has been argued that the same resources would be far more
beneficial to agriculture with superior distributional effect if directed
to increase public investment in irrigation and other agriculture related
infrastructure.While these concerns are well recognised, it
has not been possible to change the system of pricing nitrogenous fertilisers.

e] Labour Market Controls

An important area untouched
by reforms thus far is the labour market. Indias labour laws, which
apply to all industrial units employing more than 100 persons, make it
difficult for firms to either shed excess labour or to close down unviable
units. Indian firms complain that labour market rigidities make it difficult
to achieve the levels of efficiency and competitiveness needed to survive
in the more competitive and more open economic environment. They also
discourage entrepreneurs from investing in relatively labour intensive
areas, which not only reduces employment below its full potential but
also introduces an additional bias against exports since Indias
exports are typically at the labour intensive end of the spectrum.

Labour rigidities also make
it difficult for Indian companies to undertake much needed restructuring.
Indian companies in the past were encouraged to enter into diverse lines
of production outside their areas of "core competence", often
setting up plants of sub-optimal scale because the industrial environment
provided assured protection from international competition with very limited
domestic competition. In the new more competitive environments these companies
need to consolidate their position in core areas, where they must modernise
and expand, while selling off other units to other entrepreneurs in a
better position to manage and modernise them. Such restructuring should
normally take place through mergers and acquisitions, but it is more difficult
in India because potential new owners are unwilling to take over existing
units if they are burdened with surplus labour. They would rather set
up a new unit, even though restructuring may be much cheaper if labour
laws were less rigid.

It is sometimes argued that
labour problems in India are exaggerated by inefficient managements as
an excuse for management failures. Certainly, many well run firms have
been able to shed excess labour through generous voluntary retirement
schemes. The costs incurred are significantly higher than the statutory
minimum compensation payable under the law, but this only reflects the
fact that the statutory compensation requirements are very low. Restructuring
through mergers and acquisitions has also become more common, especially
after 1996. The attitude of labour unions has also changed considerably
because of competition in product markets. Labour intransigence beyond
a point in a competitive market situation only weakens the unit relative
to its competitors and therefore militates against the interest of the
labour employed in the unit. However, these factors do not negate the
case for more rational labour laws. On the contrary, as protection levels
are lowered further in future, Indian industry will need all the possible
efficiency gains it can achieve to be internationally competitive and
greater flexibility in the labour market will be an important pre-requisite
to achieve this goal. This is an area in which there is very little consensus
anywhere in the political spectrum at present, but such a consensus will
have to be developed.

f] Public Sector Reforms

Despite suffering from all
the familiar problems experienced by other developing countries with a
large public sector, the approach to public sector reforms in Indias
approach to public sector reforms has been much more cautious than elsewhere
that of other developing countries. Radical solutions such as outright
privatisation of commercially viable units and closure of unviable units,
which have been attempted in many countries elsewhere, were eschewed to
begin with, in favour of a much more cautious approach. In the 1980s public
sector reform focussed on increasing the functional autonomy of public
sector organisations to improve their efficiency. In the 1990s this was
combined with "disinvestment" involving sale of a portion of
the government equity in public sector enterprises while retaining majority
control with the government attempting to improve the performance of public
sector enterprises (PSEs) as much as possible without rejecting public
ownership as an inherently inefficient arrangement. Nevertheless p.

Unlike privatisation a la
Margaret Thatcher, which was driven by the conviction that government
control makes public sector units inherently less efficient and privatisation
therefore improves economic efficiency and is good for the consumers,
59. Since the late 1980s efforts to reform the public sector have focussed
on granting PSEs greater functional autonomy from the government to enable
them to function as commercial enterprises. The need for more autonomy
is indisputable. Public sector enterprises in India operated under a suffocatingly
large number of guidelines laid down by government over the years many
of which has lost their relevance but were never withdrawn. Many critical
decisions taken by PSEs, including investment decisions, needed separate
approval by the government. Complete independence from government in a
situation where the government owns the company, appoints the Chief Executive
and is responsible to Parliament for the actions of PSE managements is
impossible. However, steps have been taken to give PSEs greater operational
freedom. Almost 700 guidelines accumulated over the past several years
were withdrawn. Nine of the best performing public sector units have been
given special status, with greater delegation of financial power to make
investments, enter into strategic alliances, raise capital from the capital
markets, etc. without seeking government approval. The Boards of these
PSEs are proposed to be broad based by appointing non-government directors
with the objective of making these PSEs truly Board managed companies
in due course.

The second leg of the strategy
for public sector reform was partial privatisation under which a portion
of government equity (initially limited to 49%) would be sold to private
investors. This was the policy of disinvestment in India was initially
motivated largely by the need to raise resources for the Budget. Equity
sales took place intermittently through the post reform years, and by
1997-98 the government had sold varying proportions of equity, ranging
from 5% to 49%, in 50 public enterprises, generating a total revenues
of of over Rs.8400 crores in the processfor the Budget. Partial privatisation
of this type can be legitimately criticised on the grounds that it is
unlikely to yield the efficiency gains associated with full privatisation
including transfer of management. However, it needs to be recognised that
even the induction of minority private shareholders makes some difference.
It rules out budgetary subsidies to the enterprise, which is an important
improvement in incentive system. Public sector managers in partially privatised
PSEs become much more conscious of market indicators of performance such
as earnings per share, dividends and share prices, and this creates greater
commercial orientation. Many public sector units also acquired private
investors, including international portfolio investors by making fresh
issues of equity in international markets for the purpose of raising funds
for their expansion programmes. The presence of international stakeholders
has helped create a climate in which PSE managers are able to extract
greater de facto autonomy from the government.

Over time, the insistence
on maintaining government control in public sector enterprises was steadily
diluted and a broader consensus evolved towards eliminating government
control in some areas. The United Front Government. I in 1996, established
a Disinvestment Commission was appointed charged and specifically requested
the Commission to identify units in "non-strategic and non-core"
areas where the government stake can be reduced to a minority or even
zero. The Commission has examined 50 public sector enterprises and recommended
disinvestment of a majority stake, with transfer of management control,
in several cases. Implementation of these recommendations has been slow,
but effective privatisation in a few PSEs, with a majority stake and effective
management control being offered to private sector investors now appears
very likely in 1998-99. This clearly heralds a very different approach
to public sector reform and this approach has been further reinforced
by the BJP governments announcement that the government stake in
public sector enterprises will be reduced to 26% "in the generality
of cases".

62. It is difficult to evaluate
whether these efforts to improve the performance of the public sector
have made a difference in practice. Available data on the financial performance
of the public sector enterprises in the post-reform period are summarised
in Table 9. They clearly show that the profitability of all public sector
enterprises as a whole has improved significantly in the post-reform period.
Gross profit (before deduction of interest) as a per of cent of capital
employed was 10.9% in 1990-91 and increased to 16.1% in 1995-96. Since
the economic environment became much more competitive over this period,
it is reasonable to assume that increased profitability reflects improvements
in operational efficiency.

The area of public sector
reforms where very little has been done relates to the treatment of chronically
loss making public sector enterprises making losses. While some of these
units can be turned around, many have been making losses for a very long
period of time and are unlikely candidates for revival. The government
ruled out sSummary closure of these units and was ruled out in the early
years of the reforms and the government decided instead that the scope
for reviving each unit would be carefully examined and only those units
where revival was found to be economically feasible would be revived while
others would be closed down. The feasibility of revival was to be determined
by the Board for Industrial and Financial Reconstruction (BIFR) and government
would take a decision based on the Boards recommendations. Several
public sector units have been identified as fit for closure through this
process, and the government has even decided on closure in many cases,
but no unit has been actually closed because the decision has been challenged
in the courts by labour unions. The BJP Government in its first Budget
announced a generous retrenchment package to be offered in cases of closure
in order to overcome labour opposition.

Has this combination
of partial privatisation, combined with some effort to increase public
sector autonomy, led to improved performance of the public sector? Available,
data on the financial performance of the public sector enterprises in
the post-reform period (Table 9) show that the profitability of public
sector enterprises as a whole has improved significantly in the post-reform
period. Gross profit (before deduction of interest) as a per of cent of
capital employed was 10.9% in 1990-91 and increased to 16.1% in 1995-96.
Since the economic environment became much more competitive over this
period, it is reasonable to assume that increased profitability reflects
improvements in operational efficiency.

As in so many other areas
of structural reform, it seems reasonable to conclude that a process of
public sector reform has clearly begun and the scope of what is feasible
is now seen to be much wider than was the case initially. Bolder efforts
at privatisation of the public sectors are called for, not only to mobilise
larger volumes of resources which would help reduce the fiscal deficit
but also to generate greater efficiency in the public sector.

g] Private Investment
in Infrastructure

It was recognised early in
the reforms that a faster growing economy would need major investments
in infrastructure and these investments could not be financed solely in
the public sector. Private investment to supplement the public sector
efforts was seen as the solution and new policies were announced to encourage
private investment (including foreign investment) in power generation,
telecommunications services, ports and roads. There has been some success
in this area but the results thus far have fallen considerably short of
expectations. In retrospect it is clear that the difficulties in attracting
private investment into regulated sectors such as infrastructure were
underestimated. Infrastructure sectors have many special characteristics.
Tariffs are controlled and public interest issues are invariably involved.
Private investors have to deal with a number of government agencies and
are also subject to their regulatory control to a much greater extent
than elsewhere. In these circumstances, special efforts are needed to
create a policy environment in which good quality private investors will
be encouraged to invest.

The experience of private
investors in power and telecommunications provides many examples of problems
which could have been avoided if the policy framework had been designed
to deal with these difficulties.

The early power projects
were criticised on the grounds that the cost of private power was too
high. This criticism gained credibility because tariffs were fixed on
the basis of a cost plus formula which inevitably attracts the charge
of cost padding. It could have been avoided if tariffs had been determined
on the basis of competitive bidding, as was done later.

Private sector power producers
wanted fuel supply contracts which protected them from risks of fuel
supply interruption by providing for sufficient compensation in the
event of non-performance by either the public sector coal supplier or
by the railways which have to transport coal to the power plant. Such
contracts had never been signed for coal supplies to public sector projects
and there was reluctance on the part of public sector suppliers to accept
new obligations for private sector projects. The power policy had not
anticipated the need to mitigate fuel supply risk.

Private sector telecommunications
projects could not achieve financial closure because lenders insisted
that in the event of debt service default by the original licensee,
the telecom license should be assignable at the option of the lenders
to a new operator. The terms of the license under Indian law did not
provide for easy assignability and new provisions had to be devised
to meet these requirements. This was an important source of delay in
implementation.

Private sector telecom
operators claimed that the interconnection charges levied by the public
sector network were too high making it impossible to the new operators
to compete with the existing public sector operator. In this connection
they complained that the regulatory framework was inadequate because
the Government was both the regulator and the owner of the public sector
network. Private operators demanded the establishment of an independent
regulatory authority to adjudicate on disputes with the public sector
network. This demand was conceded and the Telecommunication Regulatory
Authority of India was established in 1996 . This has helped increase
confidence levels but the scope of its authority is narrower then the
private operators would like.

Cellular licenses were
awarded through competitive bidding on the basis of the license fee
bid. Subsequently market demand proved to be less then anticipated making
these projects unviable at the agreed license fees. The licensees have
appealed to the government for an adjustment of the license fees and
an extension of the period of the license. The government is considering
whether such adjustments can be made at this stage consistent with the
public interest and how to ensure transparency if this is to be done.
In retrospect, a revenue sharing arrangement would have provided a better
method of protecting against the downside of market risk.

68. TThese problems illustrate
the fact that a great deal of preparatory work is necessary if private
investment is to play a significant role in infrastructure development.
In particular, it is necessary to have much greater clarity about the
regulatory framework within which the private sector will operate. The
aim should be to create as close to a competitive situation as possible,
with an unbundling of risks so that private operators can take on only
those risks which it is reasonable to expect them to take. Since the complexity
of these problems was not fully realised when the policies were initially
introduced, there was a great deal of "learning by doing".

Fortunately, some learning
has taken place and many the process of private sector infrastructure
projects have taken off successfully. The first two private sector power
projects are now in commercial production and several others are at various
stages of implementation construction. Private telecommunication services
(both cellular and basic) have commenced in various parts of the country.
A major expansion of the Jawaharlal Nehru Port at Mumbai involving doubling
of the container handling capacity is being implemented on a BOT basis
by a private consortium. Several minor ports are being built entirely
in the private sector. Roads are the most difficult area for private investment,
but a few small private sector toll road projects are being implemented,
while other larger projects are being planned for the future. The extent
of progress in this area can be seen from the figures for total loan approvals
for private infrastructure projects by the All India Financial Institutions
which have increased from Rs.5880 crores in 1995-96 to Rs.22,255 crores
in 1997-98. The disbursement figures also show an increase from Rs.2332
crores to Rs.6505 crores in the same period.

h] Reforming the Financial
System

Reforms in the financial
system are critical for the success of sStructural reforms if only because
the latter aim at reallocating real resources in the economy and this
process needs to be supported lubricated by an efficient financial system.
I The efficiency of the financial system is especially important in the
context of the increasing integration of domestic and financial markets
as is evident in the recent East Asian experience, where weaknesses in
the financial systems are now seen to be an important cause of the currency
crisis that engulfed the region. Indias reform programme therefore
included a concerted effort to reform banking and capital market institutions.
There has been steady forward movement in these areas. These reforms were
to be extended to the insurance sector, but this has not yet taken place.

i] Banking Sector Reforms

71 Banking sector reforms
were first initiated in 1992, based on the recommendations of the Committee
on the Financial System (Narasimham Committee), and the first stage focussed
on interest rate liberalisation, improvement in prudential norms and standards,
strengthening supervision, and increasing competition in the banking sector.
In 1997, the United Front government appointed a second Committee on Banking
Sector Reforms also under the chairmanship of M. Narasimham to review
what had been accomplished and to chart the agenda for a second stage
of banking sector reforms. The second Narasimham Committee submitted its
report in 1998 and its recommendations are expected to guide banking reforms
in the years ahead.though much more remains to be done.

72 The pace of banking sector
reforms exemplifies gradualist change. The achievements thus far are substantial
though a great deal remains to be done.

In 1991, iInterest rates
were have been almost completely de-controlled since 1991 when both.
T the interest rate on government debt as well as the deposit and lending
rates of the commercial banks were strictly controlled. was artificially
fixed at a low level, supported by mandatory requirements for banks
and insurance companies to invest high proportions of their assets in
government securities. The banking system was also subject to strict
interest rate regulation. The Reserve Bank of India (RBI) prescribed
the structure of deposit rates for term deposits of different maturities,
and also the structure of lending rates with different rates for different
categories of borrowers. There has been a major liberalisation in this
area. Mandatory requirements for investment by banks in low interest
government securities have been sharply lowered and interest rates on
government securities are now determined by the market on the basis
of periodic auctions conducted by the RBI. Deposit rates have been completely
deregulated and lending rates have also been largely deregulated, except
for two a concessional rates for loans below Rs.25,000 and loans between
Rs.25,000 and Rs.200,000.

3India made a relatively
early beginning, compared with other developing countries, in upgrading
Pprudential norms and standards relating to capital adequacy, income
recognition, asset classification and provisioning have been upgraded
and brought into closer alignment with, in line with the Basle Committee
recommendations, and enforced full compliance over a 3 year period.
These standards have been fully applicable since 31st March,
1996. The second Narasimham Committee has recommended further tightening
of these norms to ensure full alignment, and this will be done in phases.

External supervision of
the banks has been strengthened to monitor and evaluate bank performance
on the basis of the new prudential standards. This has made the financial
condition of the banks more transparent focussing attention on the size
of the non-performing assets (NPAs) of the banking system. Performance
in this area has been encouraging. The net NPAs of public sector banks
as a proportion of their commercial advances declined from 16.3% to
9.2%.

4 The degree of Ccompetition
in the banking system has been increased significantly as new private
sector banks have been given licenses and foreign banks have been allowed
to expand much more liberally than in the past. The share of business
of private sector banks and foreign banks has increased from around
10.6% in 1991-92 to 17.6% in 1996-97. Public sector banks still dominate
the system, but greater competition among public sector banks is beginning
to make an impact on their behaviour.

These reforms are already
changing the way banks function. Higher prudential standards are forcing
the banks actively to seek quality borrowers in order to improve their
asset quality. Interest rate liberalisation gives the banks flexibility
to offer borrowers more attractive interest rates. Quality borrowers on
their part are also able to demand better terms because of competition
among banks and because the opening up of both domestic and foreign capital
markets, enables them to look for cheaper sources of funds outside the
banking system. All of this adds to competitive pressure favouring better
In short, better regulation and competition is working to the advantage
of better quality borrowers which should improve the allocative efficiency
of the system.

5 However, the reforms still
have a long way to go. As pointed out above the existing prudential norms
need to be further tightened and fully aligned with international practice.
More importantly, reforms in banking are about changing the way banking
institutions function. A liberalised and more open economy, with freer
flow of capital, will place particularly heavy demands on the system.
Bank margins will be threatened as better quality clients gain access
to other sources of funds especially in international markets. Banks will
have to develop much stronger credit appraisal skills than were necessary
in the past to reflect the more competitive environment facing borrowers
and the consequent higher risk of failure. A liberalised economy also
involves exposure to greater volatility in both exchange rates and interest
rates and credit appraisal techniques must take account of the impact
of uncertainties on these counts on the quality of the loan portfolio.
Static measures of asset quality need to be supplemented by methods of
assessing asset quality in the face of uncertainty. Handling these challenges
calls for basic restructuring of management systems in banks and massive
upgradation of staff skills.

The next stage of banking
sector reforms also requires parallel improvement in the legal system
relating to debt recovery. Efficient banking requires a credible threat
of legal action to force recovery from defaulting borrowers. Without such
a threat, the incentive system encourages borrowers to default. Indias
legal system in these areas needs massive improvement. The government
has recognised the need for this change and a full scale review of banking
laws is being undertaken to identify the nature of legislation needed.
Early action in this area should have high priority.

A key issue in banking reforms
in the future relates to government control over public sector banks.
Public sector ownership imposes several constraints including limitations
in methods of recruitment and promotion and restrictions on the salaries
they can pay. Public sector banks are also burdened by standards of public
accountability which may be inconsistent with the degree of flexibility
needed for commercial decision making. Many credit decisions taken in
good faith can end up as non-performing assets for a number of reasons
but public sector managers are peculiarly vulnerable to accusations that
such decisions were mala fide ab initio and these accusations can often
trigger lengthy investigations by investigative agencies and also become
issues of public concern. This can lead to an overly cautious approach
on the part of bank managers impairing the speed and quality of decision
making. The Committee on Banking Sector Reforms has recommended that the
governments equity holding should be reduced to 33% which would
free the banks of constraints arising from government ownership.. No decision
on this issue has been announced thus far. The weight of international
experience is certainly in favour of moving away from government ownership,
though a consensus on this issue is yet to develop in India.

ii] Capital Market
Reforms

8Parallel with reforms in
banking iMajor changes have taken place in the capital market in the past
seven years. In 1991 Indias capital market did not have a statutory
regulatory framework. The Securities and Exchange Board of India (SEBI),
was given statutory powers in 1992 and has since laid down a structure
of regulations governing various participants in the capital markets,
including rules for insider trading, take-overs, management of mutual
funds, etc. These rules are now in operation and will need to be refined
on the basis of experience. The stock exchanges, which were earlier dominated
by brokers and lacked effective supervision, are now much better governed.
The focus of the new regulations is to ensure investor protection through
transparency and full disclosure.

9Important changes have taken
place The technology of trading has been modernised. The National Stock
Exchange introduced on-line electronic trading in 1994 and the system
today allows brokers located in 140 cities and towns all over the country
to trade in a single unified market through terminals linked by VSAT to
the NSE computers. It provides automatic matching of buy and sell orders
with price time priority, ensures transparency for investors and assurance
of the best price. Competitive pressure has led the Bombay Stock Exchange
also to introduce an on-line trading system in 1995, with linkages to
brokers all over the country.

Prior to 1996, Indias
capital market was burdened by the fact The settlement system has also
seen major improvement. Earlier, that completion of a trade involved physical
transfer of share certificates from the seller to buyer followed by submission
of the certificates to company registrars to effect changes in the register
of stock holders. The process was vitiated by long delays, frequent loss
of certificates, return of certificates because signatures of the seller
on the certificates did not match with signatures on record with registrars,
and also the danger of forged certificates. In 1996, a National Depository
commenced operations offering investors the facility of holding securities
in dematerialised form and settling trades through book entries in the
depository, eliminating delays and uncertainties in transfer of ownership.
The volume of business done by the Depository has expanded rapidly. In
June 1997 only 48 companies with a market capitalisation of Rs.94,000
crores had signed up enabling their securities to be dematerialised. By
June 1998 this had increased to 198 companies with a market capitalisation
of Rs.2,88,000 crores. The value of securities actually dematerialised
increased from Rs.2518 crores to Rs.35,000 crores in this twelve month
period.

These changes are slowly
putting in place a set of capital market institutions which can generate
confidence among investors and encourage financial intermediation in this
area. As with all institutional development, much depends upon how the
system actually functions under the new rules and regulations but a good
start has been made. The presence of FIIs, which have invested a total
of around US $9 billion in the stock markets, is an important force which
will push capital market to come closer to international standards.

iii] Insurance Sector
Reforms

82 The missing element in
Indias financial sector reform thus far relates to insurance which
remains industry by law a a public sector monopoly, a situation which
exists in only three other countries, Cuba, North Korea and Myanmar. The
industry suffers from a very high mandatory requirement for investment
of the life fund in government securities which lowers the implicit return
on insurance products. The lack of effective competition also leads to
a lack of variety in pension products available for savers. 3Reform of
the Opening the insurance sector by opening it up to new private sector
participants, with suitable regulation is clearly overdue. It will help
consumers by providing a vigorous and create a more competitive insurance
industry, offering attractive insurance and pension products, which become
especially important as per capita incomes rise, life expectancy increases
and traditional family support systems, which are a substitute for insurance
and pensions, are eroded. A vigorous insurance industry would also increase
the volume of long term contractual savings in the economy and channelise
these savings towards infrastructure sectors which have the greatest need
for long term funds.

The pace of insurance reform
in India reflects both the time taken to build a consensus on difficult
issues and also the fact that a consensus does evolve. The Congress government
had recognised the importance of reform in this area and appointed the
Malhotra Committee to look into these issues. The Committee submitted
its report in January 1994 and recommended opening up the insurance sector
to private competition permitting foreign investment with a minority stake.
No decision could be taken on this recommendation within the remaining
term of the government because of opposition from the Unions. The United
Front government in 1997 moved a step forward and announced its intention
of creating a statutory regulatory authority for insurance and also allowing
a limited opening of the the sector should be opened up pension and health
insurance segment to private sector participants to begin with. The legislation
could not be passed because the BJP at that time opposed foreign investment
in insurance. Insurance sector reforms are an unsaturated part of financial
sector reforms which should be high on the agenda for the future In 1998
the BJP Government announced that it will open up all sectors of insurance
for Indian companies, but the extent of foreign investment to be allowed
in these companies is yet to be decided. The Finance Ministry has proposed
that foreign investors (insurance companies) may be allowed upto 26% of
equity, with additional scope for investment by NRIs taking the combined
total of foreign equity to 40%. A final decision on this proposal has
yet to be taken. The area of consensus on insurance has clearly widened
considerably over the years but it has taken a long time. It is worth
noting that even if the Finance Ministrys proposal is approved,
legislation will have to be introduced in Parliament to give effect to
the decision and the earliest this process could be completed will be
sometime in 1999. This will be more then five years after the Malhotra
Committee submitted its report !

i]
Policies for Poverty Alleviation

The impact of the reforms
on the poor has been a constant focus of the policy debate in India. Supporters
claim that the reforms will help the poor by encouraging rapid and efficient
growth, which in Indias circumstances means labour using employment
generating growth, and this is the only sustainable way of reducing poverty
to any significant effect. Critics claim that this process will take time
especially if reforms are implemented at a gradualist pace and large sections
of the population may therefore not benefit in the early stages. Some
sections may even be hurt as certain kinds of products and processes are
displaced by structural changes brought about by the reforms. Indias
reform programme sought to deal with these problems by combining structural
reforms with strong poverty alleviation programmes to ensure an adequate
flow of benefits to the poor even in the short term.

From the outset, the reforms
emphasised a continuing commitment to the traditional programmes for poverty
alleviation which existed even before the reforms. These included direct
support of consumption of the poor by subsidised sale of foodgrains through
the Public Distribution System, employment programmes providing wage employment
in public works type projects especially in rural areas and a variety
of self-employment programmes involving provision of a combination of
capital subsidy, credits and technical assistance to set up micro-enterprises
in both rural and urban areas. Fiscal constraints in the first two years
of the reforms prevented any large increases in these programmes but there
was a substantial expansion from 1993-94 onwards.

The effectiveness of these
programmes in achieving their stated objective varies considerably. Parikh
(1997) has shown that the public distribution system is a very inefficient
instrument for helping the poor since the entitlement of subsidised supply
is available equally to all households and in practice the poor have less
access to the system. The spread of the PDS varies considerably across
the country and most of the offtake is accounted for by a few States where
the PDS is well organised and these are not the States where poverty is
most concentrated. In 1997 the United Front government tried to introduce
better targeting in the system by distinguishing household below the poverty
line which would obtain their entitlement at a lower price, but it is
too early to judge how effectively this is being implemented. The other
poverty alleviation programmes are better targeted, especially those providing
wage employment, and it is generally agreed that they have helped to provide
income support to lower income groups. The experience with self-employment
programme is much more varied. While reasonably well targeted it is not
clear that they provide a sufficiently stable additional flow of income
to the beneficiaries.

As the reforms progressed
the approach to poverty alleviation was broadened to include efforts to
improve the supply of social services especially health education and
family welfare. This focus was spurred by the recognition that India lags
far behind most other developing countries in this respect including most
countries in sub-Saharan Africa which are otherwise regarded as least
developed. As pointed out by Dreze and Sen (1995) Indias social
development indicators at the start of the reforms were lower then in
the East Asian countries three decades ago which suggest that unless significant
improvement take place in these indicators, it may not be possible to
achieve growth rate of 7 to 8 % as envisaged by the reforms. Larger investment
in the social sectors is regarded as necessary not only because social
development is an end in itself, but also as a precondition for accelerating
growth.

Trends in the Central government
social services expenditures as a percentage of GDP in the post-reform
years are summarised in Table 10. These show a marginal decline in the
first two years of the reforms, when the fiscal situation was under severe
pressure, followed by a steady increase after 1993-94. However, the real
problem in this area relates to expenditure in the States which account
for the bulk of social services expenditure. As shown by Guhan (1995)
social service expenditures at the State level as a percentage of GDP
declined steadily in the post reform years up to 1994-95 and this decline
swamps the increase in Central government expenditure so that the trend
in consolidated expenditures shows a steady decline.

The poor state of social
indicators in India is obviously not a consequence of the reforms but
a reflection of prolonged neglect of this crucial area in the pre-reform
years. However the trend of the past few years is clearly alarming and
has to be reversed. Remedial action lies primarily in the domain of the
States and this underscores the importance of fiscal reform and restructuring
at the States level. In practice this means that States must take hard
decisions to electricity tariffs to reduce the large losses of the State
Electricity Boards, increase water charges to reduce the very large operating
deficits of the irrigation system and also reduce losses of the State
Road Transport Corporations. These corrections would ease demands on State
Government budgets from these sectors enabling the States to expand social
sector expenditures. A major effort in this area, combined with continuing
reforms is probably much more important for poverty reduction than marginal
expansions in the traditional poverty alleviation schemes even though
these are often seen to respond more directly to the demand for tackling
poverty. In fact, the present levels of leakages from these programmes
are so high that major improvement is needed in administrative arrangements,
including involvement of NGOs, to improve the effectiveness of these programmes
before attempting any significant expansion on their scale.

34. Conclusions

4 Indias achievements
in the past seven years as far as economic performance is concerned are
clearly impressive. The recovery from the 1991 crisis was exceptionally
swift and the post stabilisation period saw a significant acceleration
in growth compared with the growth rate before the reforms. The rate of
growth in the four years 1994-95 to 1997-98 averages 6.9 %. This amounts
to growth in per capita GDP of over 5 percent per year. Poverty may have
increased in the first two years after the crisis, but this was not because
of the reforms and in any case, the deterioration was reversed by 1993-94.
It is likely that Thereas economic growth accelerated in subsequent years,
the incidence of poverty also resumed its earlier declining trend.

The good performance thus
far does not mean however that high growth rates will be easy to maintain,
let alone accelerate, in future. The slowdown in 1997-98 and the continuing
crisis in East and South East Asia raise legitimate concerns about the
pace at which India can grow in the near future. The Asian crisis has
proved to be deeper and is likely to be more prolonged than was initially
expected and its depressive effect on world growth and on India is likely
to continue in 1998-99. The imposition of sanctions by some countries
following the nuclear tests by India and Pakistan in May 1998 has added
new uncertainties, the scope and duration of which is not yet clear. However,
even if we assume that the sanctions are temporary or their effect is
marginal, it is clear that the international environment facing in India
in the next two years will be less supportive than in the recent past.
World trade is likely to grow more slowly, competition from South East
Asia will intensify, and the environment for capital flows to emerging
market is likely to be more restrained. All this suggests that India will
have to make additional efforts to ensure that the post reforms growth
rate is maintained.

The reforms underway are
clearly wide ranging and have yielded good results thus far, but they
need to be further strengthened. A credible signal that reforms will continue
and a clearer statement on the time path of reforms will increase confidence
among investors both domestic and foreign. The fact that three different
governments have endorsed the broad direction of reforms indicates that
while there may be differences in emphasis and even more so in presentation,
there is also a substantial consensus on many of these issues. This should
help to insulate economic policy from perceptions of political uncertainty
which are perhaps unavoidable in an era of coalition politics.

Where reforms have already
begun they should be swiftly completed preferably with a clearly announced
time frame. Examples of such continuing reforms are the reduction in protection
levels, continuing reforms in banking, decontrol of petroleum prices,
reform of the power sector etc. An important positive factor for the future
is that the productivity gains from many of these ongoing reforms have
yet to be realised. For example, the new investments made responding to
the

more open environment gained
momentum only in 1995-96, when corporate investment and foreign investment
picked up (Tables 4 and 8) and the benefits from these investment will
materialise only in the years ahead. Similarly, reforms in the public
sector and in the financial system are as yet at an early stage, and the
improved allocational efficiency from these reforms are only just beginning
to be realised and should provide significant efficiency gains for the
economy in the future.

There are also many areas
where reforms have not yet gained momentum and these will now have to
be addressed with urgency. An obvious area for priority attention is the
continuing high level of the fiscal deficit of the Centre and States combined.
Unless this deficit is reduced significantly, the economy will not be
able to transit to a regime of low real interest rates which, with efficient
financial intermediation, can give a boost to private investment. This
calls for a two pronged approach. It will be necessary to restructure
of Government expenditure by restraining inessential expenditure while
increasing government expenditure in important areas. It also calls for
further tax reform, especially in excise duties, and a strengthening of
the tax administration to increase buoyancy in tax revenues. These efforts
can be supplemented by much bolder efforts at privatisation of the public
sector generating larger revenues from privatisation. There is much greater
acceptability of privatisation today than was the case even two years
ago and this new consensus should be used to strengthen policies in these
areas.

Infrastructure bottlenecks
are likely to be a binding constraint on even achieving 7% growth over
the next few years. Indias infrastructure system is clearly overstrained
and has suffered from under investment in the post reforms period. Massive
investments will be needed in both the public and the private sector to
overcome this bottleneck. The two are not alternatives because the need
is so great that even the most optimistic projection for private investment
will leave a large proportion of the need to be met by the public sector.
Public investment in infrastructure depends crucially upon the ability
to raise resources in the public sector and this in turn depends upon
the ability to levy user charges. Reform of power sector tariffs, introduction
of road user charges (either direct in the form of tolls or indirect in
the form of a cess on petrol and diesel earmarked for road development)
and rationalisation of railway fares are all extremely important in this
context.

These efforts at expanding
public investment in infrastructure must be supplemented by a vigorous
effort to attract private investment by creating an environment which
is attractive to private investors. This includes simplification and transparency
of various clearance procedures, a policy framework which allows the various
risks involved in infrastructure projects to be unbundled so that private
investors are expected to take only lthose risks which it is reasonable
for them to bear, and a credible and independent regulatory framework
which assures private investors of fair treatment. Fortunately a number
of private sector infrastructure projects in power, telecommunications
and ports have taken off and the process could gain momentum.

The pace of private investment
in infrastructure will of course depend upon the availability of finance
for such projects especially debt finance. There are limits to the amount
of foreign currency exposure which infrastructure projects can take since
the tariff in most cases is fixed in local currency and this limits the
extent of foreign exchange risk which the project can take. Infrastructure
development in the private sector will therefore depend crucially upon
the availability of long term debt finance for such projects at reasonable
interest rates. This will depend partly upon macro-economic developments,
especially the ability to reduce the fiscal deficit, and partly on the
pace of financial sector reform especially insurance. Early implementation
of reforms in insurance will clearly help to stimulate private financing
of infrastructure.

Finally, India cannot afford
to ignore the poor state of social indicators relating to health and education
which has resulted from prolonged neglect of the important area over the
decades. Other countries, starting from a similar situation have been
able to improve the level of social development over time through determined
public action. Some States in India have also done so; Kerala is the best
known example but more recently Tamil Nadu has made excellent progress
in literacy and fertility and Himachal Pradesh has also shown significant
improvement in literacy and primary schooling. This is clearly an area
where the public sector must play a dominant role. Indeed, the role of
the State needs to be redefined to withdraw from direct involvement in
areas which can be easily privatised and to expand in areas such as the
social sectors where the State is the natural, and in most cases, the
only agent.

To summarise, the process
begun in 1991 has proceeded steadily if not as rapidly as its should have
but the changes already made and those currently underway are impressive.
At the same time there are formidable challenges ahead many of which will
involve forays into more difficult areas than has been necessary hitherto.
It is essential to make steady progress in addressing these new challenges
if India is to achieve the objective of 7 to 8% growth.

* The author is currently
serving as Member of the Planning Commission, Government of India. The
views expressed in this paper do not necessarily reflect the views of
the Commission. Thanks are due to Isher Ahluwalia, Surjit Bhalla, Nirvikar
Singh and T.N. Srinivasan for helpful comments on an earlier draft.

References

Guhan. S, "Social
Expenditure in the Union Budget, 1991-96" Economic and Political
Weekly May 6-13, 1995